LONDON (Syndicate Project)- Do you believe in fairy tales? If so, you could probably make good money today as a financial trader or gain power and prestige as a central banker.
While annual inflation in the United States, the eurozone and the United Kingdom has spiked to 40-year highs and will likely hit double digits after the summer, financial markets and central banks look confident that the war against rising prices will be over by Christmas and that interest rates will begin to fall next spring.
If this happens, the world economy will soon return to the perfect financial conditions of the Goldilocks fairy tale that have fascinated investors for the past decade: not too hot and not too cold, and always just right for profit.
“ The question is whether the new era now dawning will be dominated, for the first time in a generation, by persistently rapid price growth; or whether, for the first time in history, we will painlessly get through an inflation crisis with negative real interest rates and without the collateral damage of a major recession.”
Investor optimism can be seen in the trillions of dollars recently wagered on three closely related market bets. Money markets are now predicting than US interest rates FF00,
it will peak below 3.5% in January 2023 and then decline from next April to around 2.5% in early 2024. Bond Markets TMUBMUSD10Y,
they have a price that US inflation plummets from 9.1% today to just 2.8% in December 2023. And SPX stock markets,
Assume that the economic slowdown caused by this unprecedented disinflation will be mild enough that US corporate profits will drop. increase 9% in 2023 from record levels this year.
Central bankers are more nervous than investors, but they are reassured by their economic models, which are still based on updated versions of the “rational expectations hypothesis” that failed so miserably in the 2008 global financial crisis. These models assume that Expectations low inflation are the key to maintaining price stability. Thus, central bankers see “well-anchored” inflation expectations as evidence that their policies are working.
When central bankers and markets succeed each other, both are likely to go astray. But this explains only in part the willingness of the financial markets to bet against warnings by eminent commentators like Larry Summers, Mohamed El-Erian, Jim O’Neill and Nouriel Roubini of a return to 1970s-style stagflation.
Shop to the sound of cannons
I just spent three months traveling the world discussing with hundreds of professional investors why I too have switched to an unequivocal bearish outlook, after a decade of Panglossian optimism about the outlook for financial markets. These discussions have convinced me that investor confidence today is based on four fallacies, or at least cognitive biases.
The first cognitive bias is to downplay and challenge geopolitics, a view summed up by Nathan Rothschild. legendary instruction in the Napoleonic wars to “shop with the sound of cannons”. Professional investors pride themselves on trading against terrified retail investors selling their assets due to wars.
This contrary approach has often been proven correct, though with one glaring exception. The October 1973 war between Israel and a coalition of Arab states led by Egypt and Syria permanently turned the world economy in a way that ruined a generation of overconfident investors. They downplayed events eerily reminiscent of today: an energy shock, rising inflation after a long period of monetary and fiscal expansion, and bewilderment among policymakers who faced simultaneously high inflation and rising unemployment.
Squeezing Russia, one of the world’s largest producers of CL00 energy,
and many other commodities outside of global markets has triggered a supply shock that is at least as severe as that of 1973-74. Arab oil embargo and will last for years. Therefore, restoring price stability now will require a long-run demand constraint strong enough to match the reduction in commodity supply. That implies an increase in US interest rates to 5%, 6% or 7% instead of the peak of 3.4% that investors and central banks now assume. However, the Pavlovian reflex of investors is to play down this geopolitical turmoil and focus instead on small adjustments in US monetary policy.
fashion is your friend
This stance reflects a second cognitive bias, summed up in the investment saying “the trend is your friend,” which implies that changes In the market, economic indicators such as inflation, unemployment or interest rates are more important than your levels.
As a result, many investors believe that monetary conditions have tightened too much because central banks have raised interest rates in 0.75 percentage point increments instead of the usual 0.25 percentage point, even though rates remain still much lower than in any previous tightening cycle.
Similarly, investors seem unconcerned about inflation rising above 9% because they expect it to drop to “only” 7% by December. But businesses and workers in the real economy will still see prices rise at their fastest pace in decades, sure to drive corporate pricing strategies and wage negotiations by 2023.
Don’t fight the Federal Reserve
Such a conclusion seems obvious, except for financial traders subject to a third cognitive bias: “Don’t fight the Fed.” This market-favorite saying asserts that once the US central bank is serious about achieving a goal, such as an inflation target, investors should always assume that it will get away with it.
This makes sense when the Fed is genuinely prepared to do whatever it takes to meet its targets, for example by clearly pursuing low inflation regardless of the effect on unemployment, stock markets and debt service costs. But today’s Fed is so focused on “well-anchored” inflation expectations that it’s pretty relaxed about “hindsight” data that continues to show prices rising much faster than most businesses and workers expect. they have never seen.
Nothing new under the sun
That leads to one final bias: Most people find it hard to imagine events that have never happened in their lives. For many investors and policymakers, stubbornly high inflation falls into this category. The wisdom of the market expresses this bias with the adage that “there are no new eras”.
But new eras are upon us, as the world painfully learned in 1973. And the current interaction of Russia and COVID-19 with monetary and fiscal expansion has created unprecedented conditions, guaranteeing that the period ahead will be very different from the last 40 years.
The question is whether the new era now dawning will be dominated, for the first time in a generation, by persistently rapid price growth; or whether, for the first time in history, we will painlessly get through an inflation crisis with negative real interest rates and without the collateral damage of a major recession. Markets and central banks confidently await a new carefree era. If they’re right, we can all live happily ever after.
Anatole Kaletsky, Chief Economist and Co-Chairman of Gavekal Dragonomics, is the author of “Capitalism 4.0: The birth of a new economy after the crisis” (Public Affairs, 2011).
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